It starts off with such good intentions: a new partnership, the honeymoon period, various bonds and guarantees as to performance. However, the older we get the more we see linger on longer than the parties wanted.
We are gathered here today to consider an omnipresent issue across the various interlocutory marriages present on a construction project.
The complexities of construction projects are widely accepted. However, there is a propensity for the industry to accept that a building contractor on a delayed project is probably entitled to some damages, but to not really care to understand the mechanisms for assessing and understanding any entitlement.
This article will focus on loss suffered and expense incurred by a building contractor’s head office resources, due to a project being delayed.
When a contractor tenders for a new project, it submits a tender sum based on that project taking ‘n’ days to complete. This price will include both site and head office overheads and profit. Should the project take longer to complete, the contractor is entitled to seek damages from the client.
Note three salient considerations of this article:
(i) project overheads are different from head office overheads; we are focusing on the head office overheads of the contractor;
(ii) we are not discussing liquidated damages of the client; in the UAE this is usually a prescribed daily figure (AED ‘x’) in the contract, so the calculation is simply the number of days delay multiplied by AED ‘x’ (subject to Article 390 (2) of the UAE Civil Code);
(iii) aside from (ii) above, this article considers damages, that being the cost incurred by the contractor; this cost should not include mark-up for profit.
The three gates
The first gate for a contractor to pass is establishing the period of delay for which it is entitled to redress. A delay analyst can opine on compensable delay, allowing for concurrent delay and so on.
The second gate involves demonstrating that it is reasonable to believe the contractor would have secured work elsewhere if the delay on the project had not occurred (for example, if the contractor was going bankrupt, it may be unlikely that it would have secured further work).
The third gate to pass regards demonstrating that the overhead and profit allowance in the contract was reasonable (while simultaneously deducting the profit in order to only claim damages).
Notably, many large building contractors would be content with 3% company-wide profit from the array of high-value work they carry out. However, most building contracts in the UAE include a diluted head office and project office overhead and profit mark-up of 10-15%. Owing to resource availability, potential lack of understanding or strategy, most contractors understandably claim for the full percentage mark-up, at least at first. In turn, an astute client contests the probable disparity between what the contract says and what the auditable head office accounts prove, as a way to block this third gate and quash this claim.
If the parties accept the principle that the contractor is entitled to damages, the discussion moves on to calculating the entitlement.
Loss of opportunity or actual cost
The contractor can calculate this entitlement based on loss of opportunity, or by demonstrating actual cost incurred. Loss of opportunity claims rely on the success of the contractor in demonstrating that it would have profited by moving its resources from the delayed project onto another project. The contractor was held back from making ‘AED y’ elsewhere, thus it is reasonably entitled to that ‘AED y’ from the client.
The actual cost approach requires the contractor to demonstrate the actual loss suffered by its head office as a result of the delay. That is not easy.
Resultantly, contractors tend to prefer the lost opportunity approach as it is simply calculated, using a formula. This is less time-consuming and usually produces a higher figure than actual cost.
There are three formulas commonly used to calculate the head office overhead:
(i) Hudson formula
(ii) Emden formula
(iii) Eichleay formula
The Hudson formula relies on the percentage agreed in the project contract as the factor for considering entitlement. However, in reality this percentage may bear no resemblance to the contractor’s actual head office overhead cost. This is a primary criticism of the Hudson formula, but also a major reason why this formula is often a contractor’s first choice.
To be more accurate, this formula should be adjusted to account for the likelihood of the contractor securing work elsewhere in a timely manner, inefficiencies and the like. Insofar as this factor is not based on auditable calculations, it is still subjective. Therefore, to do so would defeat the purpose of using a simple formula.
In the UAE, this formula is generally used as a ready reckoner or starting point when looking to settle a claim.
In light of the Hudson formula attracting criticism for being too simplistic, Emden’s Building Contracts and Practice published an alternative, the Emden formula.
This formula divides the total overhead cost of the contractor’s organisation by the total turnover. This results in a percentage based on the contractor’s actual head office overhead, instead of one contained in an isolated contract. This is advantageous.
The Emden formula received judicial support in England and Wales. It was widely used until a loss of opportunity approach fell out of judicial fashion, in favour of trying one’s best to demonstrate actual loss. This downfall was largely attributable to the (non-construction) case of Tate & Lyle vs Greater London Council (1983). Following this lull, loss of opportunity claims have resurfaced as a result of the difficulty in demonstrating actual loss; judges are growing more understanding of this difficulty.
I state the stance in the England and Wales jurisdiction as background, but one must remember concepts formed in Common Law jurisdictions should be treated with caution in the UAE, where Emden’s formula is not as commonly used except in arbitral proceedings, mainly because contractors are reluctant to disclose auditable head office overheads. Ironically, this is the greatest advantage of Emden’s formula.
Depending on the strength of the circumstances, a contractor may recognise that it cannot prove loss of opportunity, and therefore an actual cost approach is required. The Eichleay formula may be useful in this case.
The Eichleay formula compares the value of work carried out in the contract period with the value of work carried out by the contractor as a whole for the contract period. The contractor can then be apportioned a share of head office overheads using the same ratio, to provide a lump sum. The allocable amount of head office overheads to the given project is divided by the contract period, which can then be multiplied by the number of days delay to provide a total sum claimed.
Is the end formulaic?
Industry professionals will advise on a case by case basis, but using formulas to calculate damages due to a contractor is a widely accepted industry norm. The circumstances of the project and the dispute resolution forum inform whether a simple formula like Hudson’s is appropriate to demonstrate loss of opportunity, or whether Eichleay’s formula is more prudent to demonstrate actual loss.
A contractor needs adequate records to pass the three gates considered earlier, so remember the mantra “records, records, records!” Keep detailed records in order, and these interlocutory marriages of construction projects will be simpler to conclude, in the event they do last longer than planned.
Craig Gibson is a senior manager at Omnium International.